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An Oil-Price War’s Surprise Ending

No one expected shale producers to survive extended low oil prices.

The oil market’s oversupply – and the low prices that followed – was supposed to drive shale producers out of business. Instead, the economies of several large national producers have been upended, and the next act could prove even more destabilizing.


© REUTERS/Lucy Nicholson

OPEC’s 171st meeting in Vienna on November 30 saw an important shift in the global oil market, with member states agreeing to slash production by 1.2 million barrels per day – around 1 percent of global output.  It’s a significant move to tackle the oversupply that has driven down prices. But the OPEC gathering also reflects a new paradigm: After two years, the Saudi-led price war to drive American shale and other “high cost” producers from the market is over. And to the surprise of many – not least the Saudis – shale has survived. What now?

The United States Energy Information Agency (EIA) expects persistent market oversupply to have been quenched by the second half of 2017. The Saudis view the diminishing oversupply as an opportunity to cut production – and they agreed to take on the largest cuts, slashing 486,000 barrels a day. They also worked intensely to coordinate cuts with Russia, which promised to limit output by up to 300,000 barrels a day. Just a day after the Vienna meeting, prices jumped from $50 to $52 per barrel.

The Saudi plan did face numerous obstacles. Iran had refused to participate in any cut, insisting it should first be allowed to re-establish production it lost under years of sanctions. In response, the Saudis threatened to boost their own production, punishing Iran by collapsing prices and denying them market share. The Financial Times’ Nick Butler correctly characterizes this as “playing with fire,” and not only because of the severe pain this would impose on weaker OPEC states, but also for the geopolitical retaliation it might provoke from the new US administration as the Saudis would also bankrupt numerous shale producers in the US.

In the end, the Saudis succeeded in getting Russia, Iran, and the rest of OPEC on board. But the relief is only temporary. US shale is widely expected to expand into the void, re-depressing prices by later next year. In all these scenarios, the future remains extremely difficult for OPEC, for Russia, and for other oil-dependent states.

A Price War Backfires

Oil prices began to rise in 2002, dipped during the financial crisis and rose again steadily through mid-2014. That sustained period of high prices spurred the development of unconventional shale production. Driven by technical innovations in hydraulic fracturing along with abundant venture capital, the US added more new oil to the global market by 2014 than all of what was lost during the Arab Spring revolution and subsequent wars in Libya, Iraq, and Syria. By mid-2014, some two million excess barrels-per-day (bpd) were flowing into storage, and the price collapsed.

Facing unprecedented surplus production, the Saudis insisted that OPEC alone could not cut enough production to boost prices without sacrificing immense market share. However, Russia and other non-OPEC producers would not join any cut, while Iran, Iraq, Nigeria, Algeria, and other OPEC members demanded “hardship exemptions.” This led the Saudis to instead push OPEC to maintain production levels, further driving down prices in an attempt to force US fracking – believed to be too expensive – out of business. Soon, the Saudis, Iraq, and other OPEC states plus Russia were all increasing production, intensifying their low-price pressure on shale and jockeying for market share before sanctions expired on Iranian production. But they were chasing a moving target.

How Has Shale Survived?

Fracking was supposed to be expensive, with an initial gush of oil or gas dissipating and soon requiring additional fracking. But all this has now changed.

First, fracking is more like a manufacturing process than conventional oil production. Shale producers were able to innovate at phenomenal rates – the Permian Basin in Texas, for example, has shown gains of 500 percent over several years. Horizontal well drilling was accelerated, shrinking labor and rig costs. Initial production per new well was also increased substantially.

Second, fracking’s domestic financial backers demonstrated surprising loyalty in spite of high debt and risk levels, reducing bankruptcies below all expectations. And when bankruptcies, mergers, and acquisitions did take place, they generally brought fresh financing, preserved technical capacity and further rationalized operations, producing more robust companies.

All in all, firms in richer regions remained profitable when oil was in the $40s, and survived losses incurred – especially between November 2015 and April 2016 when prices descended to the mid-$20s. It is important to note that OPEC and Russia require high profits to support their oil-dependent national budgets – generally in the $80s – while private US shale firms demonstrated they can pay loans and thrive with modest profit margins in the $40s. How much lower further tech and operations innovations can take them remains to be seen.

Tech advances recently caused the US Geological Service (USGS) to declare an additional 20 billion barrels of West-Texas Permian Basin oil as recoverable – the largest continuous addition in US history. And beyond North America, similar deposits in Argentina, China, and Russia could flourish with capital, expertise, and infrastructure.

In short, shale portends a new era of abundant and generally cheap oil and gas likely to last some decades. Of course, major political disruptions in the Persian Gulf or Russia could usher in a new era of high prices, as the bulk of global conventional oil is produced there. And if global producers continue to under-invest while prices remain low, capacity could be swamped by a demand surge. But the resource base is not in doubt – it only requires investment, time, and effort.

Geopolitical Implications

Revenue shortfalls for highly oil-dependent Russia, Saudi Arabia, and Iran don’t bode well for future relations in East and Central Europe, the Caspian, or the Middle East and North Africa. These three regions have seen their budgets tightened and spend reserves worn thin, and their room for compromise has diminished.

Energy is already central to Russia’s relations with Ukraine, its diplomacy regarding European and Asian pipelines and other energy deals, and its new Mideast focus. The conflicts in Syria, Yemen, and Iraq are all cases of intensified armed contention and collusion among these states as competition on the oil market increases.

Meanwhile, America’s shift towards net-oil-exporter status could make an aggressive Trump administration overconfident in confronting Iran or the Saudis should the latter undermine US shale producers.

The least volatile geopolitical scenario would be for the Saudis to succeed in cutting production as they have now vowed to do, boosting prices and stabilizing national budgets. Howard Hamm, the fracking billionaire close to Trump, told Bloomberg ahead of the OPEC meeting that he hoped his fracking colleagues would react to a production cut with “discipline,” maintaining higher prices. This reflects a widely shared view in the US energy business that mutual interests will work to preserve the decades-old US-Saudi oil market (and geopolitical alliance). But it’s just as likely that the US confrontation with Iran will intensify collaboration with the Saudis; re-imposing oil-sale sanctions on Iran would certainly make life easier for the kingdom – and all other producers – by reducing stubborn global supply surpluses.

Undermining Energiewende

Finally, there will be significant consequences for climate change mitigation strategies, such as Germany’s Energiewende, or energy transition. It was formulated under very different expectations about remaining oil and gas resources and the prices renewables would have to face. The new hydrocarbon abundance contradicts deep-seated beliefs in “peak oil,” the “end of the age of hydrocarbons,” and “perpetually high” oil and gas prices – ideas that underpinned more than thirty years of environmental strategy.

Indeed, cheap, abundant, increasingly fracked oil will have complex and destabilizing geopolitical and climate consequences requiring careful analysis – and action.

NB. This post was updated on December 1, 2016 to reflect OPEC’s decision to reduce production.